Magazine

Prices: How High Is Up?

March 07, 2004

Suddenly, there's a whiff of inflation in the air. Raw-material prices are soaring, boosted by heavy demand out of China. The dollar is weakening, pushing up the prices of goods imported into the U.S. And a host of companies -- from steel mills to chemical manufacturers -- are jacking up prices after years of being unable to get anything in the way of a hike. The bottom line: The more than two-decade-long decline in inflation that began when Paul A. Volcker took over the reins at the Federal Reserve in 1979 is over. Inflation has bottomed out and is headed up.

Should we worry? Probably not. The return of corporate pricing power is not to be feared. Rather, it's a sign of an economy on the mend. Thanks to the Federal Reserve's easy monetary policy, the economy is finally gathering steam after spending three years trying to shake off the excesses of the late 1990s. Consumer prices jumped 0.5% in January, their biggest increase in nearly a year, as goods prices excluding food and energy stabilized after falling for 16 straight months. While there's always a chance that prices could accelerate sharply now that inflation has turned, what's more likely is a gentle rise, allowing companies to increase their profits and shift their focus from cost-cutting and payroll-pruning to expansion and hiring. "There are encouraging signs that pricing power is beginning to come back," says Morgan Stanley economist Richard B. Berner. "That's good news for Corporate America and the economy."

THE PRODUCTIVITY RIDDLE. There are a lot of wild cards, to be sure. Because of production cuts by OPEC, oil prices have stayed stubbornly high -- crude is up 17% since last June, in fact -- and could confound the experts by rising further still. With the U.S. heavily dependent on imported oil, that's the sort of inflation America doesn't need. Productivity growth is another question mark. It has been running at a 5%-plus clip, and no one, not even Fed Chairman Alan Greenspan, seems to know why. A sudden tailing off in productivity could lead to a burst of inflation as companies scramble to raise prices to cover higher labor costs.

Looming in the background, of course, is the specter of China. With its ultracheap labor and rapidly growing manufacturing sector, the country in effect has been exporting deflation to the U.S. by flooding America with low-priced goods. But the deflationary downdraft coming from China and the rest of Asia may soon diminish. Indeed, some economists, including Wells Fargo & Co.'s (WFC) Sung Won Sohn, even think Asia could become a source of inflation for the U.S. next year.

If that happens, it would be because of the exchange rate. After holding its currency at 8.28 to the dollar for a decade, Beijing is expected to allow the yuan to appreciate some 5% this year. That would help quash nascent signs of inflation inside China. Yet for the U.S. and other big importers, it would raise the price of Chinese goods, further contributing to inflationary pressure. It would also enable other Asian nations that compete with China, such as Taiwan and South Korea, to allow their currencies to rise and the price of their exports to increase without fear of losing market share.

What's more, this year's rise of the yuan is not likely to be the last. Instead, it's probably the start of a gradual currency appreciation over the coming years as China moves toward a more flexible exchange-rate system. "It is going to be a multiyear phenomenon," says Donald H. Straszheim, president of Straszheim Global Advisors Inc.

NEW PRICING POWER. Whatever happens in the future, there's no doubt that China's voracious demand for everything from oil to copper is spiking raw-material prices right now. Since the middle of last year, commodity prices have risen 14%, according to a Goldman Sachs Group Inc. index.

The steel industry has been particularly affected. China's appetite has pushed up steel-scrap prices by 35% so far this year. That has led some U.S. minimills that also use scrap to make steel to consider petitioning Washington for a ban on exporting it. Coal prices are also climbing because of Chinese buying, boosting the industry's energy costs.

But thanks to the revival of the economy, steelmakers have been able to pass on those higher costs to their customers -- and then some. The industry, including U.S. Steel Corp. and Nucor Corp., raised prices on Jan. 1 by about $30 per ton, imposed a $30 surcharge for higher input costs as of Feb. 1, and then announced further price hikes of $50 to $60 per ton for April. "The economy appears to be growing," notes U.S. Steel Chairman and CEO Thomas J. Usher, explaining the ability to hike prices again and again. "Capital expenditures seem to be rising."

The economic turnaround engineered by the Fed is giving companies pricing power by helping to bring demand more closely in line with supply. Corporate America, too, is doing its share to bring the economy back into better balance by working on the supply side of the equation. After expanding their operations at a 6.4% annual clip in the late '90s, manufacturers increased capacity just 1% last year, according to Fed data. They plan another small increase this year.

In January, manufacturing companies ran their plants at 74.6% of capacity. That's the highest level in more than two years -- though well below the long-term average of 80%. In some industries, however, capacity utilization is running at high levels. Not surprisingly, they're the ones having the most success with price hikes. One sector with healthy utilization is the semiconductor industry. Leading-edge chip factories are running nearly flat out, fueled by strong demand for personal computers and a revival of corporate tech spending. That's providing an opportunity for chipmakers to jack up prices significantly. Spot prices of some 256-megabit memory chips have jumped as high as $5, from $2.93 a year ago.

Demand from China isn't the only factor pushing up prices. The weak dollar is having an effect, too. The 40% fall of the dollar vs. the euro over the past two years is driving up prices of European cars sold in the U.S. The average sticker price of those autos topped $43,000 in January, up $4,300, or 11%, from January, 2002, according to research provided by the Edmunds.com Inc. auto Web site. Prices of Japanese cars are also up, but by a more modest 4.6%, reflecting the smaller 20% fall of the dollar against the yen.

Of course, the biggest cost that companies face is labor. Thanks to hot productivity growth, those expenses have been plunging. But even productivity bulls like Greenspan believe that productivity growth is bound to slow as the economic expansion matures and companies find that they've already wrung most of the inefficiencies out of their businesses. Indeed, productivity grew by 2.7% in the fourth quarter, vs. 9.5% in the third. "If productivity does continue to grow at around 3%, unit labor costs will stop falling and will actually begin to rise moderately," says Peter Hooper, chief U.S. economist for Deutsche Bank Securities.

It's always a bit scary when prices start to pick up. History is full of examples of out-of-control inflation, and there's always the worry that such a spiral could undercut the economy's nascent recovery. But that scenario is unlikely. Even with the Chinese-led surge in global demand, there's still plenty of excess capacity worldwide to prevent prices from skyrocketing. Until that surfeit is worked off, the revival of corporate pricing power is to be welcomed, not dreaded. By Rich Miller in Washington and Peter Coy in New York, with Dexter Roberts in Beijing, Michael Arndt in Chicago, Kathleen Kerwin in Detroit, and bureau reports